World: Psychological Factors Play Key Role In Investment

Prague, 8 September 1998 (RFE/RL) -- The world has seen huge swings in stock market prices in recent weeks, in the wake of the Russian financial crisis. Whether in New York, East or West Europe, Latin America or elsewhere, markets have been battered by waves of selling. Despite some subsequent upward surges, the markets are still unsettled and uncertain.

Yet almost everyone agrees that Russia is a marginal player in the world economy. It produces only about 2 percent of the globe's Gross Domestic Product (GDP), and few countries have such extensive links with Russia that they are fundamentally threatened. So why the massive reaction? The answer can be found largely in factors lying beyond strict economic considerations, and which are to be found in individual investors' minds. Qualities like hope, fear, caution, intuition, confidence -- or the lack of them.

The free market economic system, when coupled with proper regulation, has a proven record as a creator of general prosperity. But is the emotional factor a flaw of its workings? For instance, if pessimism gains the upper hand in a particular situation, panic selling may ensue, whether or not this is justified by the underlying economic fundamentals. On the other hand, is the emotional element an unavoidable part of system in which the individual has the freedom to choose between different ways?

"If you think of eminent economists like Keynes and others, they were very well aware that psychology and sentiment is more than half of your business cycle. That means you have to take full account of these sentiments in your economic forecasts"

Rosenstock says these emotions are not irrational, they are simply present, and they reflect what people see and hear, and what they project into the future. He goes further, saying that trying to separate human factors from technical economic fundamentals is a mistake:

"They are portrayed as something standing on their own. I think they are not. People's behavior and sentiment are a such a fundamental as GDP growth, inflation and other indicators. This sentiment and fear and aspirations are as much a factor guiding the business cycle and economic development as does capital stock, investment and inflation."

If one works on the assumption that emotive behavior cannot be removed from the market mechanism, then the next step is to put safeguards into the system to prevent excessive emotion producing irrational results. This has been done in recent decades through various means, such as a halt to stock market trading to give panicky investors time to recover their nerves. There are also limits placed on risky practices like borrowing money to pay a small part of the value of stocks, with a promise to pay off the rest with the expected profits.

The chief analyst in Europe with the Industrial Bank of Japan, Eckhard Schulte, also notes the emotional element in the market, with its accompanying dangers. But he too says these fears are mostly not irrational.

He says Russia's troubles have sparked investors' worries about the possibility of similar events in other parts of the world. Using German banks as an example, he notes that apart from their exposure to Russia, they have quite high exposure to Hong Kong -- an economy which is in trouble -- and also to China, an economy under pressure. Likewise, Spanish banks have wide exposure to Latin America, another area under pressure. Therefore, on account of such broader patterns, the market is uncertain.

"People are cautious and are looking for situations similar to that of Russia, they are looking to see for instance which country has a huge degree of short-term indebtedness, which country has a high dependence on raw materials, and so forth. That can bring countries very quickly under pressure."

Schulte says that the fears of the market are often well-grounded in that difficulties do in fact exist.

"In most cases you really have some kind of underlying 'mis-development' in these economies, and it is too simple to blame speculators only for currency crises. It was the same story in the Asian countries, which really did have problems. They had huge bubble economies, they had over-investment, plus a lot of hot capital present, and once investors realized this and withdrew their money, then those economies were really in trouble".

In an ideal world, of course, wise choices by individual investors as well as transparency of business and government dealings would produce an investment environment with fewer alarms and shocks built in. In the meantime, analysts say the financial world must continue to refine the practical mechanisms while taking human emotions under consideration.